What is the October effect?

The October effect refers to the belief that stocks tend to decline during the month of October

In this article, we’re going to explore an interesting psychological expectation that investors seem to harbour that stocks usually go down in October. Although this is not backed by statistical evidence, it is interesting to understand why people think this way and whether there’s a rational explanation to how this started.

Understanding how the October effect started

The October effect’s origins stem from a series of significant market crashes that occurred in this month. The most notable include:

• The Panic of 1907: A liquidity crisis triggered a bank run and a sharp decline in stock prices.
• The Black Tuesday Crash of 1929: The stock market crash that marked the beginning of the Great Depression of 1930.
• Black Monday of 1987: The Dow Jones Industrial Average plunged over 22% in a single day, the largest single-day percentage decline in history.

These dramatic events, coupled with the general psychological association of October with Halloween and potential market scares, fueled the perception of an October effect.

Is this backed by statistical science?

A closer look at historical data paints a different picture. While some studies suggest a slight dip in average stock returns in October, the effect is insignificant, statistically speaking. In fact, some studies show October to be a slightly positive month for stock performance on average.

Perception fuels the October effect

Here are some common explanations to how the October effect prevails even in the sophisticated stock markets of today:

• Anchoring bias: Investors, aware of the October effect, usually anchor their expectations to historical crashes in October, leading them to anticipate a decline and potentially triggering sell-offs based on fear rather than fundamentals. This is what is also sometimes called a self-fulfilling prophecy.
• Confirmation bias: News and media outlets have often sensationalised market downturns, especially in October. This might lead investors to selectively focus on negative information especially in October, reinforcing their existing belief in the effect.

Alternative explanations

There are some other factors that could explain why major historical crashes all occurred in October.

• Seasonal factors: End-of-quarter portfolio adjustments by money managers might lead to some volatility, but not necessarily a sustained downturn.
• Random chance: The stock market experiences ups and downs throughout the year. A few major crashes happening in October doesn’t necessarily establish a causal link.

Staying away from the October effect

• Focus on long-term fundamentals: Market performance is driven by company performance, economic factors, and global trends. It would do you well to analyse individual companies and the overall market health rather than succumbing to seasonal anxieties.
• Historical context: Recognize that past performance isn’t necessarily indicative of future performance. A few historical crashes in October don’t establish a guaranteed pattern.
• Diversification is key: Spread your investments across different asset classes and sectors to mitigate risk. A diversified portfolio is less susceptible to short-term market fluctuations.
• Develop a disciplined investment plan: Create a well-defined investment strategy aligned with your risk tolerance and long-term goals. Stick to your plan and avoid making impulsive decisions based on market noise.
  

And you could take advantage of the October effect too! If you see markets consistently falling during October while fundamentals remain strong, buy up! This way, you will be reducing the average cost of your investments in the long-term without compromising on the intrinsic value of the asset.

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